Shrinking a deadweight loss

A proposal to reform Social Security

"Thanks to the high elasticity of labor supply, we can reform the Social Security system in a way that honors promises to the old and that also makes the young better off."
—Ed Prescott

Although "pay as you go" is the standard term used to describe our Social Security system, "pay and pray" might be more accurate. Workers pay into the system for many years, funding benefits for current retirees. They've just got to hope that when they retire, somebody else will be paying into the system so they, too, can collect.

Given the age structure of America's population, with its looming tidal wave of baby boomer retirees, things don't look good. If trends continue, the ratio of workers to retirees will soon shrink dramatically, so payroll income will diminish just as benefits expenditures need to increase.

But after noting how strongly workers respond to changes in tax rates, Ed Prescott sees hope. "Thanks to the high elasticity of labor supply," he noted in a recent interview, "we can reform the Social Security system in a way that honors promises to the old and that also makes the young better off."

The trick is to change incentives. Under the current Social Security setup, a person nearing retirement age has no incentive to stay in the labor force. "If you work an additional year, you pay a lot of additional taxes," Prescott observed. "But you get no additional benefits—they just pick your 35 highest-earning years."

But if the system were changed so that an additional year's labor would actually increase retirement benefits, more people would stay in the labor force. "If people could get something close to an actuarially fair amount of what they pay in, it changes the incentives a lot," said Prescott. "And I think it would be good to keep people busy and active when they hit those years."

A proposal for reform

Prescott proposes that the current pay-as-you-go scheme be transformed into a fully funded system in which workers are given the option of establishing individual retirement accounts with the government rather than sticking with the existing 10 percent Social Security payroll tax. (The actual Social Security tax rate is 12.4 percent, but a portion is used to provide disability and survivors insurance.)

From every paycheck, according to Prescott's plan, 8.7 percent of earnings would go into the individual account and earn a 4 percent real return annually—the after-tax real return that has prevailed in the United States in the 1880 to 2002 period. Upon retirement, the savings from the account are paid back to the worker, on an annuitized basis.

Older workers might well opt to stick with the existing pay-as-you-go system, but younger workers would tend to choose individual accounts. Providing the option allows a transition period that's generationally equitable.

One version of Prescott's reform proposal—which assumes that people under 38 will choose the individual accounts—would lower the marginal tax rate on labor sufficiently to evoke an 8 percent increase in labor supply and produce welfare gains of 4 percent for young and future workers. Other versions that alter the tax rate according to a person's birth date would produce even greater gains by reducing overall marginal tax rates to 27 percent, increasing labor supply 11 percent and overall welfare by 9 percent.

It's the closest thing in economics to a free lunch. "There's a big deadweight loss that can be shrunk," said Prescott, "and that gain can be given to people."

But he emphasizes that there are a number of equity considerations to take into account. In the real world (unlike his model's world) some people earn higher wages than others—Prescott suggests that lower-income people should be allowed to contribute more of their wages to their accounts than high-income people. And since some low-income people may not earn enough to provide for retirement regardless, means-tested supplementary benefits should be provided.